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Subprime Mortgages

LOYOLA UNIVERSITY CHICAGO ECONOMICS FORUM AND GRADUATE SCHOOL OF BUSINESS. Subprime Mortgages. Professor A.G. (Tassos) Malliaris Walter F. Mullady, Sr. Professor of Economics and Finance Loyola University Chicago November 6, 2007. Key Topics. Background Developments Definitions

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Subprime Mortgages

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  1. LOYOLA UNIVERSITY CHICAGO ECONOMICS FORUM AND GRADUATE SCHOOL OF BUSINESS Subprime Mortgages Professor A.G. (Tassos) Malliaris Walter F. Mullady, Sr. Professor of Economics and Finance Loyola University Chicago November 6, 2007

  2. Key Topics • Background Developments • Definitions • Data and Graphs • Assessments

  3. Tentative Assessment • Steady increases in Housing prices • Housing as an asset has lower risks than equities • Low interest rates that attempted to minimize wealth losses in equities fueled increases in housing prices

  4. Mortgages • Total Mortgages • Subprime Mortgages are loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history • 1995: $65 Billion • 2007: About $ 800 Billion

  5. Mortgages Are The Largest Credit Market

  6. What The ABX Indices Imply For Home Prices • So with every jiggle in the ABX, the high yield market follows. This begs the question, what do the ABX numbers say about the state of the subprime housing market? In order to answer this question, we will employ J.P. Morgan’s ABX fair value model for this discussion (detailed in their July 20 conference call). • This top table shows what kind of housing market is implied by current ABX prices. The bottom table shows what level of defaults correspond to the housing market scenario implied by ABX prices. Highlighted in red is the scenario implied by yesterday’s closing prices. • A few observations: • There is no consistency in the pricing among tranches. The AAA, AA and A tranches are pricing a housing disaster on par with the Great Depression (down more than 27% over the next 5 years) while the BBB- tranches are pricing in a flat housing market. Such inconsistencies suggest irrational pricing. • A lot of commentators have called lower-rated BBB and BBB- tranches “toxic waste.” The ABX market agrees as some of the current prices imply bond writedowns of over 80% for the BBB- tranches. • Many are over-reading the price movements of the ABX indices. In the lower-rated tranches of BBB and BBB-, a move of 3-to-5 points does little to change the implied outlook for housing and writedowns. This, however, does not prevent high yield from reacting to a small jiggle in these indices as a major “repricing of risk.”

  7. How Many Mortgages Were Originated? … • The table to the right shows the total number of mortgages and gross values originated between 2004 and 2006. It breaks them down by initial interest rate. This is the key period of originations that has everyone concerned about some sort of breakdown. Mortgages originated before 2004 have enough of an equity cushion thanks to home price appreciation through 2005 that they do not present a concern for the marketplace. • Some stats: • A total of 25.9 million mortgages were originated with a gross value of $5.377 trillion. The average mortgage was $207,000. • A total of 8.4 million adjustable-rate mortgages were originated with a gross value of $2.3 trillion over this critical three year period. This is 32% of all mortgages or 42% of all gross value originated. The average adjustable-rate mortgage was $272,000. • A total of 17.6 million fixed-rate mortgages were originated with a gross value of $3.1 trillion over this critical three year period. This is 68% of all mortgages and 58% of all gross value originated. The average fixed-rate mortgage was $177,000. • Any initial interest rate of less than 5.50% on an adjustable-rate mortgage, the level of three-month libor before turbulence hit the credit markets, is a good working definition of a “teaser rate.” The table specifically highlights those adjustable-rate mortgages with this teaser rate definition (italics). A total of 3.2 million mortgages representing 39% of all adjustable-rate mortgages with a gross value of $1.05 trillion or 46% of all gross value qualify.

  8. … And How Many Resets Are Left? • Mortgages Left To Be Reset • A total of 3.1 million adjustable-rate mortgages will be reset in 2008 and beyond. The gross value is $1.3 trillion, or 54%, of all adjustable-rate mortgages. • Among the adjustable-rate mortgages qualifying under our teaser rate definition (less than 5.50% as explained above), 1.4 million will reset in 2008 and beyond. Their gross value is $404 billion, or 38%, of all adjustable-rate mortgages. • Among those with an initial interest rate of less than 3.0%, only 235,000 mortgages with a gross value of $1.1 billion will reset in 2008 and beyond. Teaser rates this low are only offered for a short time with a reset soon after closing. • Mortgages Already Reset (Table Below) • A total of 3.9 million of the adjustable-rate mortgages originated between 2004 and 2006 have already reset (specifically through the end of 2007). • Among the adjustable-rate mortgages qualifying under our teaser rate definition (less than 5.50% as explained above), 1.9 million have already reset. Their gross value is $651 billion. • Among the adjustable-rate mortgages with an initial interest rate of less than 3.0%, over 99% have already reset.

  9. Then Came The Adjustable-Rate Mortgage Reset Worry The chart below, courtesy of Credit Suisse, shows when an adjustable-rate mortgage will first reset (gold line). $2.2 trillion will reset in the next 10 years with almost half this amount, or $1 trillion, coming between now and November 2008. Most of these resets will be subprime (dark blue bars) between now and next year. The peak for subprime resets is May 2008.

  10. “Official” MBA Delinquencies Statistics

  11. “Official” MBA Delinquencies Statistics

  12. Regulation • Ben Bernanke May 17, 2007: Broadly speaking, financial regulators have four types of tools to protect consumers and to promote safe and sound underwriting practices.  First, they can require disclosures by lenders that help consumers make informed choices.  Second, they can prohibit clearly abusive practices through appropriate rules.  Third, they can offer principles-based guidance combined with supervisory oversight.  Finally, regulators can take less formal steps, such as working with industry participants to establish and encourage best practices or supporting counseling and financial education for potential borrowers.

  13. Macroeconomic Implications • As of November 5, 2007: $35 billion write-offs • Federal Home Loan Banks: $163 billion • Superfund: $100 billion • Potential total losses: $300 billion? • Housing Sector • Automobiles • GDP

  14. Questions?

  15. Thank You.

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